Those of us charged with investment oversight have always been at significant disadvantage to the active managers we employ.
While the majority of institutional equity portfolios are actively managed — at substantial cost — the inconvenient truth has always been that manager skill could not be statistically detected
So managers that excel at telling stories may be more successful than those with skill.
Equity factor risk models offer a solution. These models have become the standard approach to measuring portfolio risk and constructing portfolios in the investment management community, with popular models today using over 100 underlying risk factors, most of which are not directly investable. While effective at measuring relative risk, these models are ill-suited for attribution: knowing that you underperformed because you were over-exposed to momentum or leverage at the wrong time is not terribly meaningful and certainly not actionable.
When an equity risk model is instead built for the purpose of performance attribution, and based solely on investable factors, it measures risk almost as well, but can also distinguish among return due to passive differences from the benchmark, market timing, and stock selection. This mitigates the impact of the random noise that obscures skill and makes performance data, for the first time, meaningful and actionable.
Equity portfolio return, both absolute and incremental, is a function of four things:
- the portfolio’s average exposure over time to passively available factors,
- the active changes in these exposures through time (whether intentional or not),
- trading/ randomness, and
The first of these, average exposure to passively available factors, is the most significant. For the median property-casualty company, average passive exposures explain 98.7% of absolute return and two-thirds of incremental return!
Passively available exposures explain the majority of active managers’ incremental return — isolating the impact of these exposures transforms investment oversight.
ADVANTAGES OF A FACTOR APPROACH TO PORTFOLIO OVERSIGHT:
Distinguish among passive differences, market timing and security selection
Incremental return is a combination of:
- passive differences from the benchmark,
- market timing (changes over time from the manager’s average passive exposures),
- security selection, and
- random noise.
By differentiating among passive differences from the benchmark, market timing, and security selection, factor analysis mitigates the impact of noise and reveals skill.
Detect skill: positive or negative
This improves the signal/noise ratio and makes performance data meaningful. In Why Investment Risk and Skill Analytics Matter, we show that the correlation between managers’ past and future relative performance is negative 0.3 — actually counterproductive in assessing skill — but isolating stock selection skill with a factor model results in a positive 0.3 correlation between past and future performance. Top skill decile managers are twice as likely to outperform as underperform in subsequent few years. Bottom decile managers are more than twice as likely to underperform as outperform in subsequent years.For the first time, past performance is an indicator of future performance.
Know your equity portfolio risk
P&C equity portfolio market risk exposures vary substantially across companies and through time. The amount of equity market exposure is a necessary consideration in the asset allocation decision and, as the proposed new BCAR scores suggest, a critical component of portfolio oversight.
Get what you pay for
Some active managers are hardly active at all and simply deviate passively from their market benchmark. In fact, about one-third of active managers take too little active risk to compensate for an average fee, even assuming a top-decile information ratio. Absent a risk model, you can’t know how active your managers are; with a risk model, clients need not pay for passively available exposures.
Detect early if a manager’s risk level changes.
Risk models measure market risk and other incremental risk exposures based on current portfolio holdings. Changes in portfolio risk are known immediately.
Better understand your manager’s strategy.
Equity risk models quantify manager’s true bets compared to either a benchmark market index or a peer benchmark such as the property-casualty aggregate index. Clients can ensure managers’ relative risk exposures are consistent with expressed strategy, and manager discussions can focus on those decisions that significantly impact portfolio risk and return rather than stories that distract.
Ensure multiple managers complement each other
Clients can avoid similar active bets among individual managers, offset rather than exacerbate unintended risks, avoid closet indexing the overall portfolio, and better assess how individual managers contribute to the aggregate portfolio.
Please contact us if you’d like to see your company’s current equity portfolio exposures and performance attribution, or if you’d like to try our cloud-based risk model for yourself.
Risk Modeling Articles:
Insights from an Equity Risk Model Built for Oversight
Three Holdings-Based Style Analysis Tests
Why Investment Risk and Skill Analytics Matter
Performance Persistence Within International Style Boxes
Performance Persistence Within Style Boxes
Property Casualty Industry Crowding
Returns-Based Style Analysis: Overfitting and Collinearity